Deflation Probability

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Thanks to Greg The Analyst's April 22, 2020 blog entry "Why I view this cycle as deflationary, not inflationary." for his unsourced reproduction chart of the "Income Share of Top 1% Relative to Bottom 90%" since 1920 (chart left).

I added to the chart mashup the closest comparison I could find to reflect Canada's wealth gap. The two countries track the same trend in income disparity rising from the early 1980's when state mandated interest rate inflation peaked, to now the end of 2Q 2020 when our new Bank of Canada Governor, Tiff Macklem said on June 22nd, "Our main concern is to avoid a persistent drop in inflation by helping Canadians get back to work."

"avoid a persistent drop in inflation" oh oh... apparently the members of the The Canadian Club of Montreal who are mainly from the business and professional communities addressed by the Governor are not to be exposed to the apparently scary noun... "deflation"

I will highlight below the main points of Greg's argument. ​We are indeed beginning to see the elements unfold for another great cycle of deflation, not official yet, but the evidence mounts.

Below is a mashup of "FRED" charts on Velocity of Money and the Probability of Deflation. The Bank of Canada does not publicly​ publish those metrics.
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Money Velocity

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​M1 Money Velocity has been trending down since 4Q 2007 (the "Great Recession") as unemployment rates have been rising (the 10 year change in unemployment in Canada is up 38.4% on the May 2020 data chart). The unemployed consume less; hence they save more. As consumption rates fall, GDP drops: (from 4Q 2008 to 4Q 2009, GDP dropped 1.9% and with the Covid 19 shutdown the March 2020 GDP print is down 6.8% since 4Q 2019).

M2 Money Velocity was trending up until 3Q 1997 and both employment and greater consumption (inflation) increased. The first hit to consumption came with the DotCom crash in 1Q 2000 and the Consumer Price Index began to drop and then plunge into the March 2009 Great Recession. By 2011 the commodity super cycle peaked (see the Deflation Probability chart below and the TSX Indexes chart)

The Bank of Canada's 2% CPI target and their policy framework (ZIRP & NIRP) is to "avoid a persistent drop in inflation". The most recent CPI print (April 2020) was negative at -0.2% via pandemic repricing.
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Deflation Probability

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Theses are still early days in the pandemic. New deaths from the novel coronavirus today (June 28, 2020) are the highest in Mexico. The U.S. is ranked 7th and Canada is ranked 72nd (Worldometers). Trade wars are intensifying, supply chains are being disrupted and cash flows are being diverted towards turning debt into equity. Let's take a look at Greg The Analyst's argument and the charts he used:

Charts Used:

1. Kondratieff investment "Seasons".
2. U.S. income share of the top 1% relative to the bottom 90% since 1920.
3. U.S. Dow Jones industrial price index with notations of Fed action and market reaction 1920 through 1932.
4. April 2020 forecast of U.S. job losses by sector.
5. U.S. share of wealth of the top 1% relative to the bottom 90% from 1960 to 2014.
6. U.S. distribution of wealth from 1917 to 2017.
7. U.S. velocity of M2 money stock since 1960.
8. U.S. corporate profits and employee compensation as a percentage of GDP since 1947.
9. U.S. milk production output since 2001.

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Argument Bullet Points: Why Greg's view is that this cycle is deflationary, not inflationary.

• (Chart 1) Disinflation periods see asset prices and debt levels rise as CPI, interest rates, fixed income yields drop and commodity prices drop eventually leading to stock market drops (equity share pricing).
• (Chart 1) Deflation periods see asset and consumer prices drop along with consumer confidence as rising unemployment leads to consumption and production drops as well as debt repudiation, credit contraction, spiking interest rates and currency repricing.
• (Chart 1) Inflation reignition requires demand to be much greater than supply which requires deflationary deleveraging (turning debt into equity).
• (Chart 2) In this last cycle of Disinflation, production supply became much greater than demand consumption and as the stock market equities boomed the ongoing transfer of wealth accelerated towards the top 10% leaving the bottom 90% of earners stuck at late 1990's real wages producing a collapsing middle class and no further possibility of inflation. Hard deflation rebuilds the middle class.
• (Chart 3) In the Great Depression of the late 1920's and early 1930's, the Fed tried its then version of QE but it did not prevent the Dow from a 2+ year crash. Very low operating margins from overcapacity (high supply exceeding low demand), coupled with high levels of debt creates the scenario of weak hands capitulating. 
• (Chart 4) Commodity prices, manufacturing, retail and wholesale trade, service industries and the travel, accommodation and food service sectors have all been hit by Covid 19 wiping out a decade and more of high employment.
• (Chart 5+6) A key feature of the early 1930's depression was, as it is today, the wealth gap and the broken structure of the middle class. (see my June 20, 2020 post "Household Net Worth")
• (Chart 7) The slow down in the velocity of money results from the deflationary transfer of wealth from the middle class to the top 10% which produces a change from a productive economy and investing in people to unproductive investment in financial engineering. (see my June 11, 2020 post on "CDOs Then CLOs Now")
• (Chart 8+9) The commodity super cycle ended in 2011 and by 2012 as a percentage of GDP, employee compensation crashed and corporate profits peaked. QE bailouts of corporations and the bond market by central banks over the last decade have not been inflationary for employment wages but has only exaggerated the wealth gap and increased the supply side. Inventories have spiked while demand has been dropping and now has plunged with the plague. Booms and over supply lead to busts. Rebuilding the middle class demand leads to productivity.

​Reopening Canada: 3 stages of recovery

Financial Post’s Larysa Harapyn speaks with FP’s Kevin Carmichael and Manulife Investment Management’s Frances Donald about what’s ahead as Canada starts to re-open following the COVID-19 pandemic. June 25, 2020​

DEPRESSION DEFINITION 
​(✓) = now occurring in various global economic centers.

Depressions are characterized by their length, by abnormally large increases in unemployment (✓), falls in the availability of credit (✓) (often due to some form of banking or financial crisis (✓)), shrinking output (✓) as buyers dry up (✓) and suppliers cut back on production and investment (✓), more bankruptcies (✓) including sovereign debt defaults (✓), significantly reduced amounts of trade and commerce (✓) (especially international trade (✓)), as well as highly volatile relative currency value fluctuations (✓) (often due to currency devaluations (✓)). Price deflation (✓), financial crises (✓), stock market crash (✓), and bank failures (✓) are also common elements of a depression that do not normally occur during a recession. (Wikipedia)